Friday, January 7, 2011

The problem of having too much money

Of course, there is no such thing as too much money. One man's dream is another man's basic necessity. But then sometimes there are those who don't know what to do with their money. The damn thing is burning a hole in the pocket (or the bank account, or wherever). They've already bought into houses, gold, shares, mutual funds, whatever. Now what ?

They invent instruments like catastrophe bonds. I read about them with my jaw dropping - hadn't known that such esoteric stuff existed. Well compared to other even more esoteric species of investments, this might more resemble "plain vanilla". That only underscores my point.

Insurance companies issue these catastrophe bonds. They carry a higher rate of interest and investors invest in them. The condition is that the investor loses his investment if the catastrophe occurs. So he is essentially betting that the catastrophe does not occur. For the insurance company, this is a form of reinsurance. If the catastrophe occurs, they have to pay out to those they insured, but don't have to pay out to these bond holders. Thus they reduce their risks.

For investors , their attraction is the higher rate of interest, but more importantly diversification of their portfolio. These bonds do not move in tandem with say equity markets or housing markets. They move in tandem to catastrophic events occurring or not occurring. Looks good, but .....

Look at what the investor is betting against. That another Katrina will not hit Florida or Louisiana this year. Or that an earthquake will not happen in Sichuan. Or that there won't be a flood in Bihar. Actually, these are bad examples. The market, at least for the moment, is mostly for disasters in the US. But why on earth would you want to take risks like that ??

I have long been disturbed by the societal implications of what is happening in the financial markets. Because the possibility of riches are huge, the best brains in the world go into finance. They innovate like crazy - compared to what happens there, an Apple or Google are midgets. They take incredible risks in the pursuit of even more money. They conjure up extremely complex and fiendish instruments that very few even understand, let alone operate meaningfully.

Its says something about a society that its greatest minds and greatest achievements are in the field of high finance. I am not convinced that its the most glorious claim to fame. I, for one, will steer clear of catastrophe bonds. Of course, that's merely an academic statement - there's the small problem of not having that kind of money !!